Australian dollar slammed as Bill Evans says cut, QE in October

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Macro Morning

Via Bill Evans at Westpac:

In a speech yesterday the Deputy Governor of the Reserve Bank gave a fairly clear hint that the Board is set to cut the cash rate and other key policy rates at its October Board meeting.

The Bank is also likely to extend its objectives for bond purchases to include general support for the Australian and semi government yield curves in the five to ten year maturity range. It is likely to leave this commitment open ended at this stage.

We have discussed these issues in previous notes but did not expect the action as soon as the next Board meeting as now seems to be the case.

The theme is likely to be, as we saw in March, a Team Australia moment where the Reserve Bank is directly supporting a bold Federal Budget.

The prospect of the RBA “sitting back” to assess the Budget, which has been seen as the “norm” in previous years is not appropriate for these unique times.

We now expect the RBA to cut the overnight cash rate to 10 basis points; to adopt a 10 basis point three year bond target; and to adjust the rate on any new drawdowns of the Term Funding Facility to 10 basis points. All these rates are currently set at 25 basis points , which the Governor has generally described as the effective lower bound for the cash rate.

The Bank is also likely to reduce the rate which the Bank pays on Exchange Settlement Account balances from 10 basis points to 1 basis point.

If the banks are only earning 1 basis point on their ESA balances there will be significant incentive to purchase bonds, even if the bond is only yielding 10 basis points, or lend to the private sector.

That rate will be the key to driving the effective overnight cash rate to below 5 basis points – with a risk that it could print negative on certain days.

To supplement the reduced rates, the RBA is also expected to allocate more of its balance sheet to general purchases of AGS and semi government securities in maturities between 5 and 10 years.

These purchases will be in addition to the funds required to defend the three year bond target, and will be a clear signal to governments that the Bank is committed to play a key role in supporting their increased borrowings which it has been encouraging.

The Bank is unlikely to signal a specific volume of such purchases or any monthly “timetable”. However, the policy will indicate a broadening of the objectives of the current policy which is restricted to achieving the three year bond target and addressing disfunction in the Australian and semi government bond markets.

The government spending increases are likely to be announced by the federal and state governments in their respective budgets over the next few months.

In particular, the RBA is expected to announce all these policy changes on October 6, the day of the announcement of the Federal Budget, as a Team Australia initiative.

There has already been speculation that the Board will await its forecast revisions which are available for the November meeting before committing to the policies.

Westpac is optimistic about the short term outlook but that is not what is driving this likely decision.

It is the medium term projection that the unemployment rate is still likely to be around 7% by the end of 2022 – the Deputy Governor refers to a “slow grind” – and that the shortfall in demand will be” a significant break on the recovery”.

That outlook is unlikely to change in the November forecast revisions, hence no real case can be made to “wait”.

In a note on September 11 “Next Steps for the RBA” I canvassed all these issues for an across the board reduction to 10 basis points; concluded that the moves expected above would remain “live” for all foreseeable Board meetings but assessed that there was no urgency.

The Deputy Governor’s speech and answers in the Q and A point to that assessment being an underestimate of the Bank’s assessment of that urgency.

The Speech

The take on the speech is that the RBA is concerned about the outlook for the Australian economy.

While in previous speeches from RBA officials considerable emphasis has been given to boosting the fiscal stimulus this speech focused mainly on RBA policy.

That policy discussion was in the context of a downbeat outlook for the economy’s trajectory.

He notes that the Bank’s current forecast is that the unemployment rate will still be above 7% by the end of 2022.

He noted that “Prior to the pandemic, the unemployment rate was around 5 per cent. That was not low enough to generate sufficient wage growth consistent with achieving the inflation target”.

So, in the Bank’s current figuring, restoration of the full employment rate (which through wage pressures and the resulting required narrowing of the output gap is significant for achieving an inflation target) is in the far distant future.

That means that policy needs to be very stimulatory. Indeed in the Q and A he referred to the desirability of erring on the side of over supporting the economy rather than running the risk of under supporting it.

In the speech he reviewed the Bank’s current suite of stimulatory policies including “other options for monetary policy”.

Current policy has focussed on restoring stability to the Australian and semi government bond markets and targeting the three year part of the curve since “Australian financial instruments price predominantly off the shorter end of the curve”.

The Deputy Governor gives detailed attention to the topic of “Other Options for Monetary Policy”.

He considers buying bonds further out along the curve and notes that “additional purchases could occur further out the curve on a regular basis.” He points out that the benefit of bond purchases is also a portfolio effect to incentivise investors who are seeking higher yields at the longer end of the curve to diversify into higher yielding, including potentially, foreign assets (an implied benefit would be lowering the AUD).

He also supports governments acquiring more debt – “there is not a trade off between more debt and supporting the Australian economy”.

When he came to discuss other options he noted, “A third option is to lower the current structure of rates in the economy a little more without going into negative territory. The remuneration on ES balances is currently 10 basis points. The three year yield target is at 25 basis points and the borrowing rate of the TFF is also 25 basis points. It is possible to further reduce these interest rates”.

In a speech on July 21 Governor Lowe noted, “For example ,the various interest rates currently at 25 basis points could have been set lower at, say, 10 basis points. It would have been possible to introduce a program of government bond purchases beyond that required to achieve the three year yield target.

Different parameters could have been chosen for the Term Funding Facility…. The Board has not ruled out future changes … if developments in Australia warrant doing so”.

The open ended assessment from the Deputy Governor contrasts with the “past tense” approach from the Governor.

But note that the Governor qualifies his “past tense” with “the Board has not ruled out future changes”.

It is reasonable to link these two commentaries together to conclude that the Board is now ready to take the next step as described by the Governor on July 21.

And note that since the Governor’s speech the minutes to the September Board meeting have included a “new” concept “

The Board agreed to maintain highly accommodative settings as long as required and to consider how further monetary measures could support the recovery”

Issues for the Market

The RBA will have a challenge to defend a 10 basis point three year bond rate.

However, by lowering the ESA rate to 1 basis point the excessive liquidity in the system will force the effective overnight rate down to 3 – 5 basis points. Note that in the current market the overnight rate has been around 13 basis points to reflect a 3 basis point margin over the ESA rate.

That will offer a comfortable funding margin to support the 10 basis point bond target.

Interestingly, it will provide the RBA and the banks with the potential for, on a particular day, a negative overnight rate.

Banks, which lend at a margin above the overnight rate will still not be exposed to negative lending rates but this process may provide the RBA with a test of its comfort with negative rates.

We have written extensively on this issue but recognise the Deputy Governor’s current discomfort, which was confirmed in the speech, with negative rates.

Compared to the current margin of 12 basis points over the effective cash rate the attraction of 3 year bonds offering a funding margin of around 7 basis points will be reduced but will still be sufficient margin to support the market and allow the Bank to achieve its target.

The US Treasuries three year bond rate is around 16 basis points – below the current Australian rate of 25 basis points making the Australian bond rate relatively attractive to international investors. At the new rate of 10 basis points the margin would diminish the attractiveness although the funding margin will still support some investor interest, particularly Australian financial institutions.

The new target bond will be an April 2024 – around 3.5 years further stretching the attractiveness of the 10 basis points of the three year rate.

However, because the target will relate to a specific bond the prospect of the market swamping the RBA is limited due to the restricted supply.

If the RBA decides to maintain an “elevated” ESA rate it could encounter significant difficulty in defending its target.

Non captive investors facing a slim funding margin may need to be convinced that the cash rate can go negative before the three year bond is seen as an attractive investment.

Excluding the Bank of Japan the RBA is the only central bank that has a yield targeting policy.

If an ESA rate of 5 – 10 basis points is set then I, personally, would adjust the suite of rates to 15 rather than 10 basis points to ensure a successful targeting process.

Consequently I expect that very low ESA rate of 1 basis point to be set.

Impact on Other Markets

The Deputy Governor referred to the three year part of the curve as the key for private sector borrowing costs. There has certainly been a significant impact on three year fixed rate borrowing costs from the Bank’s policies policy to set the three year bond rate and the three year TFF facility at 0.25%.

The three year fixed mortgage rate has fallen from 3.6% to 2.35% over the last year. We have been forecasting that the 25 basis point yield target and the TFF were likely to push these rates even lower.

In a recent paper we highlighted the fall in the fixed mortgage rates as key reasons behind our expectation that house prices were likely to stabilise over the course of the next year or so prior to a 15% lift over 2022 and 2023.

With prospects for fixed rates even more encouraging this confidence in the housing market is further confirmed.

Even with a 25 basis point three year bond and TFF target the three year fixed rate was likely to fall further. Under this adjustment we look for a further 15 basis point adjustment to the fixed rtaesto work through the system.

There is also likely to be some short term residual impact on AUD but we do not believe this will entail a sustained drag on AUD. Note that we are only estimating a fall in the effective overnight cash rate of around 9 basis points and our commodity price index has lifted by 37% since April.

We still believe that the key “fundamentals” of commodity prices and global risk appetite will be the drivers of the AUD in its move to USD 0.75 by year’s end.

The Yield Curve

Without doubt the yield curve will steepen but the overall level of rates can also be expected to fall. We recently lowered our forecast for the 10 year bond rate by end 2021 to 1.2%.

With the RBA assuming a more pro active role in the bond market in the 5 to 10 year part of the curve and the three year ate being targeted at 10 basis points rates yields can be expected to fall across the whole curve.

However we still expect that 5 to 10 year part of the curve will remain above US levels with the forecast ten year margin contracting from 40 to 30 basis points by end 2021.

Two months after putting the stimulus cue in the rack and declaring it isn’t nor wouldn’t monetise the virus here is the RBA monetising the virus. As it should.

The weird thing is, it seems completely shocked by its own course of actions every, single time.

Next up for the monetary glacier, negative interest rates.

David Llewellyn-Smith
Latest posts by David Llewellyn-Smith (see all)

Comments

  1. Just been speaking to someone at QLD Govt – reckons the budget is a train wreck. Payroll tax holiday plus a decline in mining royalties plus state stimulus package plus FHBG etc. Talk of slashing thousands of PS jobs — but 100 jobs created chasing unpaid fines! Seems you can’t suspend reality forever. Whocouldanode?

  2. Meanwhile the China stoush is having significant economic impacts — hundreds of ships stranded in the South China Sea waiting to land their Straya-origin cargoes: coal, iron ore and other metals. The Chinese authorities are in no hurry and every day at sea is costing Strayan miners, who are paying through the nose for the ships and crews but also not receiving the cash for the goods. No cash means no royalties for the QLD Govt …

    LNG was mentioned: royalty honey-moon for international exports still in force. The state gets almost F-all at the moment, just FYI. More genius Gubmint decision-making, the architects of which are enjoying cruises down the Rhine, no doubt … life’s grand when you’re not accountable 😉

    • costing Strayan miners, who are paying through the nose for the ships

      The contracts are typically FOB which means the end-user is the one footing the daily bill for the loaded vessel.

      • My own contracts are FOB but I wasn’t sure about mining as it’s commodities. It is commonplace for commodities traders to put cargoes on ships and sit on them until prices rise and then put them into a designated port for a customer.

        This fellow at QLD Govt seemed to think that BHP and the like were wearing the cost. But let’s say he’s mistaken: the Chinese customer bears the cost of an extra 2 months at sea and is thereby incentivised to avoid buying from a Strayan supplier in future. It’s pretty complex because there would be long-term supply contracts in place — wouldn’t surprise me if the additional cost at sea is being shared or even borne by the supplier under duress.

        • https://www.freightquote.com/blog/what-does-fob-mean-in-freight-shipping/

          How is “FOB” used in shipping documents?

          The term “FOB” is used in four different ways when it comes to freight shipping. These include:

          FOB [place of origin], Freight Collect
          FOB [place of origin], Freight Prepaid
          FOB [place of destination], Freight Collect
          FOB [place of destination], Freight Prepaid
          To understand each designation, we must first understand the difference between place of origin and place of destination and freight collect vs. freight prepaid. The first part of the designation determines where the buyer assumes title of the goods and the risk of damage from the seller (either at the moment the carrier picks the goods up for delivery or at the time of actual delivery). The second part indicates responsibility for freight charges. “Prepaid” means the seller has paid the freight; “collect” indicates the buyer is responsible for payment.

          Place of Origin vs. Place of Destination:

          Place of origin means the buyer assumes ownership of the shipment the moment the carrier picks up and signs the bill of lading while place of destination means the seller retains ownership and control of the goods until they are delivered. By denoting who “owns” the shipment, there is no ambiguity in responsibility of shipment.

          • In coal and iron ore from Australia the majority is Place of Origin FOB with the importer paying freight charges. If commodity traders are buying shipments they will typically be required to buy Place of Origin FOB and therefore take on the risk for the freight costs. At that particular time they may not have a sale point/destination resolved.

        • The increased freight costs due to the delays as well as the delays incentivise Chinese buyers to buy from elsewhere (and preferably internally I would guess)…………… in regards to contracts, not sure the Chinese deal much in long-term. (edit: in fact for coal the Chinese deal almost exclusively in spot contracts)

          • I guess the key takeaway is: someone is paying for the delays at sea, which incentivizes whichever party that is to not be a participant going forward, so either way, the costs of a transaction between parties in Straya and China increases. Which ultimately means, more expensive consumer goods in the future.

  3. Guess that last monetary shot was saved for when the fiscal stimulus was wound back. Hope to drop AUD and make borrowing even cheaper as business owners have to think about closing businesses at the same time as individuals have to think about getting a job.

  4. – Nope. Yes, short term rates will go lower but what A LOT OF people overlook is that long term rates will go (much) higher and that will be the killer for the economy. Remember the steepening yield curve ?
    – It’s the FED, RBA, ECB, RBNZ that follow short term rates, NOT the other way around. Falling rates is a sign of investors are losing their appetite for shares.

  5. – On top of that: In the last say 14 days the EUR, AUD, CAD & GBP have gone down/weakened against the USD. For all 4 currencies (it looks like) the price trend has changed from a rising one to a falling one. So, complaining that the AUD is slammed by the opinion of one Bill Evans is outright silly.

  6. Jumping jack flash

    “the Board is set to cut the cash rate”

    Yes! More debt at the same household financial situations. Bigger house prices. The economy is saved! Now we need 3rd world slaves and international students to resume.

    0.25% to 0.1% sounds like it may not make a lot of difference to the mortgage rates though. Do you think we can we get all the way down to 1% on that? Will Wespac lead the way?

    Thanks Bill. Any word on NIRP? I guess that’s next. How low can they go without NIRP? 0.01% 0.001%? How long until it makes no difference to debt eligibility of the people and NIRP is essential?